Consumer prices edged higher in January, while prices excluding food and energy fell for the first time in 27 years, supporting the Federal Reserve's contention it would keep its benchmark interest rate low for an extended period.
The tame inflation data on Friday helped calm fears that the Fed's decision to raise the discount rate it charges on emergency loans to banks, announced on Thursday, presaged a broader tightening of central bank monetary policy.
The Federal Reserve will be in a position to keep rates exceptionally low for an extended period of time. We expect no official change in the federal funds rate until late in the third quarter, said Brian Bethune, chief U.S. financial economist at IHS Global Insight in Lexington, Massachusetts.
The Labor Department said the Consumer Price Index rose 0.2 percent last month, lifted by a spike in energy costs, after increasing 0.2 percent in December. That was below market expectations for a 0.3 percent gain last month.
Stripping out volatile energy and food prices, the closely watched core measure of inflation fell 0.1 percent, the first decline since December 1982. Analysts had expected a 0.1 percent rise. The cost of new vehicles, shelter and apparel fell, as did airline fares and recreation prices.
The Fed -- the U.S. central bank -- raised the discount rate a quarter-percentage point to 0.75 percent, citing improved financial market conditions, but maintained its pledge to keep overnight interbank lending rates ultra-low.
New York Fed President William Dudley, speaking on Friday, confirmed the Fed's vow on low benchmark rates is still very much in place.
U.S. stock indexes ended marginally higher as the benign inflation report offset investors' negative view of the discount rate hike. Treasury debt prices rose, while the U.S. dollar hit an eight-month high against a basket of currencies.
TAMPING DOWN INFLATION FEARS
Fed officials see little near-term risk of inflation given that the unemployment rate stands at a lofty 9.7 percent and factories are running at only partial steam. Quarterly forecasts released by the Fed on Wednesday showed policymakers expect inflation to remain muted through 2012.
A surprise surge in prices received by U.S. producers in January, reported on Thursday, had fanned fears that inflation pressures could soon weigh on the economy, which is recovering from the most brutal recession in 70 years.
The report on consumer prices helped ease those concerns.
The inflation picture is very tame. People are hunting for value and there is not enough income growth or confidence in the labor market for people to spend in a way which provides upward pressure on prices, said Nick Kalivas, vice president of financial research at MF Global in Chicago.
Consumer energy costs soared 2.8 percent last month after rising 0.8 percent in December, and food prices climbed 0.2 percent following a 0.1 percent gain in December.
Compared to January last year, overall consumer prices were up 2.6 percent, coming in below market expectations for a 2.8 percent increase and marking a slowdown from the 2.7 percent gain seen in the 12 months through December.
Core inflation was held back by a drop in the Labor Department's measure of shelter costs, which fell 0.5 percent, the biggest drop since December 1982.
The decline reflected a 0.1 percent dip in the department's measure of homeownership costs, which accounts for a quarter of the overall CPI, and a 2.1 percent decline in the price of lodging away from home. High vacancy rates, as the real estate sector struggles to recover, are keeping rentals depressed.
A report from the Mortgage Bankers Association showed a record 15.02 percent of U.S. mortgages were in foreclosure or at least one payment past due in the fourth quarter of last year.
Weak real estate, spare factory capacity and sluggish wage growth suggested inflation would remain tame, giving the Fed room to keep its benchmark lending rate unchanged until late this year or early 2011, analysts said.
We need to see some sign of sustained labor market growth, which we have not yet seen. We need to see more signs of healing in the real estate market, said Kalivas.
There is a lot of uncertainties out there and the Fed will be fairly slow to act on the funds rate. The focus now is withdrawing all this liquidity that is in the economy and is not serving much of a productive purpose.
Compared to a year ago, the core inflation rate rose 1.6 percent after increasing 1.8 percent in December.
(Editing by James Dalgleish)